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Understanding In-House Transactions in the Real Estate Brokerage Industry Lu Han Rotman School of Management University of Toronto Seung-Hyun Hong Department of Economics University of Illinois April 8, 2016 Abstract About 20% of residential real estate transactions in North America are in-house transactions, for which buyers and sellers are represented by the same brokerage. This paper examines to what extent in-house transactions are explained by agents strategic incentives as opposed to matching efficiency. Using home transaction data, we find that agents are more likely to promote internal listings when they are financially rewarded and such effect becomes weaker when consumers are more aware of agents incentives. We further develop a structural model and find that about one third of in-house transactions are explained by agents strategic promotion, causing significant utility loss for homebuyers. Keywords: incentive misalignment, real estate brokerage, in-house transaction, agent-intermediated search, structural estimation JEL classification: C35, C51, L85, R31 We thank the editor, two anonymous referees, conference participants at the Stanford Institute of Theoretical Economics, Pre-WFA Summer Real Estate Symposium, Rotman Real Estate Microstructure Conference, AREUEA Meeting, Israel Real Estate and Urban Economics Symposium, as well as seminar participants at the Atlanta Fed, Korea University, National Science Foundation, Penn State, Seoul National University, UC Berkeley, UIUC, University of Amsterdam, and University of Toronto for their helpful comments. Contact information: Lu Han, Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, Ontario, Canada M5S 3E6. Seung-Hyun Hong, 213 David Kinley Hall, 1407 West Gregory Drive, Urbana, IL 1 Introduction Over 80% home buyers and sellers carry out their transactions with the assistance of licensed real estate agents. Yet concerns persist that incentives between real estate agents and their clients might be misaligned, thus causing a loss in consumers welfare. A growing literature has studied such incentives issues and market efficiencies in real estate brokerage markets, focusing on home sellers and their agents. 1 In this paper, we aim to contribute to the literature by examining a misalignment of incentives between home buyers and their agents, particularly involving in-house transactions, that is, transactions for which buyers and sellers are represented by the same brokerage office. In-house transactions account for about 20% of transactions in North American housing markets. In theory, in-house transactions could create informational advantages and reduce transaction costs, in which case buyers may receive higher utility from internal listings than external listings, thus resulting in efficient matches. However, given that in-house transactions help clear inventories and maximize total revenues faster, brokerage firms often pay a higher commission to reward agents engaged in in-house transactions (Gardiner, et al, 2007). As a result, agents may strategically promote in-house transactions for their own financial interest. Such strategic in-house transactions, if present, can entail a suboptimal choice for consumers in the search stage and an apparent conflict of interest in the negotiation stage. For this reason, many jurisdictions have now introduced disclosure requirements for dual agency in order to help consumers avoid unintended dual agency relationship. 2 This paper investigates strategic in-house transactions by analyzing reduced-form evidence to test their presence, and by employing structural estimation to quantify their magnitude and welfare implications. To motivate our empirical strategy, we consider a simple agent-intermediated search model and examine under which circumstances agents are more likely to strategically promote in-house trans- 1 See, e.g., Levitt and Syverson (2008a,b), and Hendel, et al. (2009). See Section 2 for more literature review. 2 Massachusetts, for example, requires that real estate brokerages and agents involved in dual agency transactions obtain informed written consent from both sellers and prospective buyers before completing a transaction (254 Code of Massachusetts Regulations b). Similar laws have been implemented in other states including Wisconsin (Wisconsin Statutes ) and Illinois (225 Illinois Compiled Statutes 454, Article 15). 1 actions. The model shows that when agents are financially rewarded by their brokerage for selling internal listings, the informational advantage of agents may compound incentive conflicts, thereby enabling cooperating agents (i.e., buyers agents) to steer buyers toward internal listings, despite the availability of better external listings. Their ability to do so, however, decreases when clients are more informed about agents incentives. Furthermore, the resulting efficiency loss for homebuyers depends on the difference in the expected matching quality buyers obtain from internal and external listings. We test these implications, using a rich dataset from the Multiple Listing Service (MLS) in a large North American metropolitan area. Our empirical strategy is akin to a difference-in-differences approach. We first exploit differences in commission structures. Specifically, agents in a traditional brokerage firm split their commission revenues with their firm on the per-transaction basis. Full commission brokerage firms, on the other hand, allow their agents to retain 100% of commission revenues but require fixed amount of upfront fees instead (Munneke and Yavas, 2001). Since the traditional brokerages revenues strictly increase with the number of either end of transactions, these firms are more likely to offer their agents higher bonuses for promoting in-house sales (Conner, 2010). Such promotion bonus would be particularly attractive for cooperating agents if commission fees they receive from listing agents are lower than the market rate. Nevertheless, these commission-related effects alone can be problematic, as the commission structure/rate could vary endogenously with the degree of matching efficiency in in-house transactions. Hence, we further examine differences in different commission incentives before and after the implementation of a new legislation (Real Estate and Business Brokerages Act, or REBBA henceforth) that requires agents engaged in in-house sales to inform their clients about the dual agency relationship in writing. To the extent that the REBBA informs consumers more about the agency relationship and related incentive issues, it can constrain agents ability to promote internal listings, but it is unlikely to affect matching efficiency in in-house transactions. Thus, the identification in our model does not require the commission rates or split structure to be exogenous. Instead, it relies on the assumption 2 that no other commission-related factors, except for the REBBA, differentially affect the incidence of in-house transactions when the REBBA was implemented. To ensure our assumption, we control for a large number of time-varying house and brokerage observable characteristics. To allow for possible time-variation in unobservable house and brokerage characteristics that may be correlated with commission variables, we also include the interaction of the REBBA with house fixed effects as well as brokerage fixed effects. In addition, we find no systematic changes in observed attributes of houses sold under different commission structures before and after the REBBA, providing reassuring support for our identification assumption. Our reduced-form results show that cooperating agents are more likely to engage in in-house transactions when they split the commission fees with firms on the per-transaction basis. This effect is stronger when they receive less compensation from listing agents. More importantly, such effects are substantially weakened after the introduction of the REBBA. Together, these results are highly in line with the theoretical predictions, hence providing strong evidence for the presence of strategic in-house transactions. Moreover, the estimated strategic promotion effect is larger when there are bidding wars. This is consistent with the notion that in hot markets buyers have less bargaining power while agents are motivated to clear inventories faster to gain new business. In light of the reduced-form evidence for strategic promotion, we further attempt to quantify the extent of strategic versus efficient in-house transactions, and evaluate the welfare consequence of strategic in-house transactions before and after the REBBA. This calls for structural estimation, because matching efficiencies are generally unobserved and hard to quantify. The key idea of our structural approach is as follows. A buyer s decision to purchase an internal listing reflects the difference between the net utility from internal versus external listings and the net cost associated with searching internal versus external listings. If her cooperating agent strategically promotes internal listings, such promotion would artificially increase the buyer s cost of searching external listings. Thus, to the extent that the idiosyncratic matching values for internal and external listings can be recovered, we can estimate 3 the implicit costs that the agent may impose on the buyer for searching external listings. To that end, we first use a nonparametric hedonic approach developed by Bajari and Benkard (2005) to recover the unobserved house characteristic and buyer-specific preferences for house characteristics. We then exploit econometric matching techniques (e.g., Heckman, et al. 1997, 1998) to recover the idiosyncratic match value that a buyer obtains from internal listings as well as from external listings. This enables us to estimate the implicit cost that buyers incur when shopping for external versus internal listings. To identify part of the cost that is due to agents promotion, we again rely on the difference-in-differences strategy, exploiting variations generated by commission variables combined with the REBBA policy, both of which are well-motivated by the theory. We find that about 64.3% of in-house transactions can be explained by buyers own preference. In this case, agents strategic promotion does not lead to a distortion in the home search process, because home buyers ex ante preference for internal listings agrees with agents interest. The remaining inhouse transactions are likely due to agents strategic promotion. For these transactions, we find that an agent s promotion of internal listings imposes a substantial cost when a buyer searches external listings. This cost outweighs the buyer s expected utility gains from purchasing externally versus internally, resulting in a suboptimal match for the buyer. Consistent with the model s prediction, we also find that such efficiency loss is larger if transactions involve smaller brokerages, relatively distinct houses, or hot markets. Lastly, we find that the REBBA has helped homebuyers make more informed choices and constrained agents ability to strategically promote, thereby increasing aggregate buyer welfare by $690 million in the sample market studied in this paper. The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3 provides the institutional background and discusses theoretical predictions about strategic promotion. Section 4 describes our data, and Section 5 presents reduced-form evidence for strategic promotion. Section 6 further develops our structural model and presents the results to quantify the extent of strategic promotion and its associated welfare loss. Section 7 concludes the paper. A full theoretical 4 model that motivates our empirical strategy is laid out in the appendix. 2 Related Literature Broadly speaking, our paper is informed by an important literature on the distortion of agents incentives (e.g., Gruber and Owings, 1996; Mehran and Stulz, 1997; Hubbard, 1998; Garmaise and Moskowitz, 2004). In light of the central role of housing markets in the recent economy, there has been substantial interest in examining the consequence of the misalignment between goals of real estate agents and those of home sellers. For example, recent work has examined the effects on selling price and time on the market of agent-owned versus client-owned properties (Rutherford, Springer, and Yavas, 2005; Levitt and Syverson, 2008a), MLS-listed versus FSBO properties (Hendel, Nevo, and Ortalo-Magne, 2009), and properties sold by traditional agents versus discounted agents (Levitt and Syverson, 2008b; Berheim and Meer, 2008). One common thread between these papers is that the current commission arrangements have resulted in a distortion of agents incentives, which in turn affects how much a house is sold for and how long it takes to sell. 3 Despite a significant interest in real estate agents incentive issues, their importance in the specific context of in-house transactions has not been extensively studied. This seems surprising given the sheer magnitude of in-house transactions and obvious incentive issues that could arise from the dual agency representation. Gardiner, Heisler, Kallberg, and Liu (2007) are among the first to study the impact of dual agency in residential housing markets. They find that dual agency reduced the sales price and the time on the market and that both effects were weaker after a law change in Hawaii in 1984 which required full disclosure of dual agency. Using repeated sales properties, Evans and Kolbe (2005) examine the effect of dual agency on home price appreciation. In addition, Kadiyali, Prince, and Simon (2012) study the impact of dual agency on sales and listing price, as well as time on the market. However, like the previous literature on the real estate brokerage, these studies focus on 3 In addition, Jiang, Nelson, and Vytlacil (2014) examine incentive issues for mortgage brokers; Geltner, Kluger and Miller (1991) examine incentive issues related to the finite duration of listing contracts for real estate agents. 5 transaction outcomes for home sellers. None of the existing work examines the consequences of agents incentives on the quality of home match, which is the key transaction outcome for home buyers. The lack of such work is in large part due to the difficulty of determining the quality of a match between a buyer and a house. In this paper, we marry the insights from the incentive distortion literature to the methodologies developed in the recent structural industrial organization literature (e.g., Bajari and Benkard, 2005; Bajari and Kahn, 2005). Specifically, we develop a structural model of in-house transactions and propose an approach to recover the idiosyncratic match value in home transaction process. By linking our empirical work to agent-intermediated search theory, we are also able to distinguish between different sources of in-house transactions ranging from strategic promotion to efficient matching. Doing so allows us to evaluate the economic harm that the incentive misalignment brings to homebuyers. Such evaluation contributes to a better understanding of market efficiency in this important industry. In this regard, our work also complements the recent literature that examines social inefficiencies resulted from free entry in the real estate brokerage industry (Hsieh and Moretti, 2003; Han and Hong, 2011; Jia Barwick and Pathak, 2015). 3 In-House Transactions in the Real Estate Brokerage Industry 3.1 Institutional background If cooperating agents interests are fully aligned with home buyers interests, there should be no efficiency loss associated with in-house transactions. However, if agents have strategic interest to promote internal listings, buyers benefits would be inevitably sacrificed, and a suboptimal match would be generated. Two characteristics of the residential real estate brokerage industry make the possible incentive issues particularly concerning for in-house transactions. First, the agency relationship in real estate transactions does not encourage cooperating agents to represent the best interests of their buyers. In a typical multiple listing agreement for a real estate 6 transaction, the listing agent has a contractual relationship with the seller, which explicitly defines his fiduciary obligations to the seller. The usual MLS agreement constitutes an offer of sub-agency to all other MLS members. The cooperating agent who brings the buyer to close the deal is deemed to have accepted the sub-agency offers and hence has fiduciary duties to the seller. Those duties effectively preclude the cooperating agent from adequately representing the buyer, even though the agent appears to work for the buyer. 4 While the conflicting loyalty by cooperating agents for buyers may seem obvious, many buyers are not aware of the agency relationship and rely heavily on their agents in searching for a home and negotiating the price of a home. The incentive misalignment problem is likely to worsen in in-house transactions, since agents from the same agency are more likely to share the information with each other and influence their clients decisions from both ends. Second, both academic researchers and market practitioners have noted that brokerage firms tend to offer a promotion bonus to agents who successfully sell in-house listings. 5 There are at least two motivations for such promotions. First, in-house transactions help the firm clear inventory faster, allowing agents to earn commissions from existing clients sooner and hence have more time and resources to compete for new clients. Second, by promoting in-house sales, brokerage can potentially influence clients decision from both sides, making a transaction easier to go through and hence maximizing the chance of capturing commission income from both ends. 6 For these reasons, cooperating agents may strategically promote in-house transactions. For example, a cooperating agent may show her client internal listings before external listings. 7 Alternatively, 4 See Olazabal (2003) for detailed discussion on the agency relationship. 5 For example, Gardiner, Heisler, Kallberg and Liu (2007) find that many brokerage firms give a financial reward to agents who successfully match internal clients with internal listings. Similarly, a popular industry practice book, Buying a Home: The Missing Manual, reports that some agencies pay agents a bonus for selling in-house listings because the agency makes more money in such transactions. In addition, a recent report by the Consumer Advocates in American Real Estate explicitly points out that agents who avoid in-house transactions may bear with some financial consequences, such as a less favorable commission split with the brokerage firm. 6 To see this, note that signing a contract with a client does not provide a guarantee for an agent to receive any commission as the transaction may not occur during the agent s contract term. This is particularly a concern for cooperating agents as they tend to have less exclusive and shorter contracts (or even no contract) with buyers. 7 Similarly, a listing agent may show his client s house to internal buyers before external buyers. In this paper, we focus our discussion on cooperating agents, but the logic can be easily extended to listing agents. 7 a cooperating agent may take her client to visit externally listed houses before visiting the internally listed house, but these external listings would be selected to appear less attractive than the internal listings that the agent tries to promote. These efforts are strategic and may lead to an in-house transaction that is inconsistent with the interest of home buyers. Of course, an in-house transaction could also occur due to spontaneous visits or information sharing. For example, a buyer may see a for-sale sign on a property

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